To Hedge or Not to Hedge FX Exposures When Volatility Spikes

By September 30, 2022No Comments

Pausing a hedging program risks undermining the perceived value of hedging by senior executives and the board.

“Should we stop hedging?” The surge in the US dollar this year against other major currencies has prompted some FX risk management teams to ask that question as well as others about hedging strategy amid disruptive volatility, bankers at Wells Fargo said at a fall meeting for NeuGroup for Foreign Exchange sponsored by the bank.

  • The questions come amid a big jump in talk about FX by CEOs and CFOs on second quarter earnings calls. Use of the phrases “currency headwinds,” “FX headwinds” and “FX losses” soared during Q2, according to data from Bloomberg that Wells Fargo presented.
  • To be sure, few if any companies will pull the plug on existing FX hedging programs. But talk about the topic provided an opportunity to review why companies might consider the move and the reasons corporates with established hedging programs should stay the course.  

Why companies might stop hedging. Wells Fargo said regret aversion—the fear of making the wrong decision—often leads companies to under-hedge or not hedge at all. When FX markets are volatile and moving against the company’s exposure, corporates may fear locking in rates below “arbitrary benchmark rates” such as FX budget rates, the bank’s presentation said. The fear of being second-guessed weighs on risk managers.

  • “The dominance of regret aversion on corporate hedging behavior is directly related to a company’s inability to employ different strategic alternatives for managing its risks, as well as weaknesses in the company’s risk management policy,” the presentation states.

The case against not hedging. Deciding to end or pause an existing hedging program during periods of volatility ignores the potential risk to a company’s financial performance, the Wells Fargo presentation said. Other reasons not to abandon the hedging ship include:

  • Stopping a hedge program undermines the reasons for implementing the program in the first place and risks changing the perception of hedging within the company, one of the bankers said. Treasury teams have often worked hard over long periods to convince senior executives and finance committees of the value of hedging.
  • Decisions to quit hedging are “most often made with no future plans” on what to do if the market continues to move against the underlying exposures, the presentation said. Nor do most companies plan what market scenarios would “define the appropriate time to re-engage and begin hedging again,” it added.
  • Pausing a program often relies on the belief that currency values will revert to the mean within short cycles or the view that current market conditions are only temporary, Wells Fargo said. But mean reversion may take a lot longer than expected. And, based on historical data, there is still a 33% chance that EUR weakens over the next 12 months, according to Wells Fargo’s Quantitative Risks Solutions group.

Stick to a systematic approach. In response to a member’s question, one of the Wells Fargo bankers said sticking to a systematic approach to hedging appears to be the right approach. His colleague recommended sticking with a “base program” but adding the flexibility in the hedging policy to “make it more dynamic,” giving risk managers the option to make adjustments—including the use of options.

  • Another member asked peers, “Anyone in the room considering pulling back from hedging in any way? We are about the exact opposite of that.”
  • A third member said his company has a lot of short positions and is considering extending the tenor of its hedges. “Where we are long,” he said, “we have to form a view and be patient.” He is considering the use of options instead of forwards, he added.
Justin Jones

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